Management Advisory Report:
The Internal Revenue Service’s Response to the Falling Level of Income
Tax Examinations and Its Potential Impact on Voluntary Compliance
June 2002
Reference
Number: 2002-30-092
This report has cleared the Treasury
Inspector General for Tax Administration disclosure review process and
information determined to be restricted from public release has been redacted
from this document.
June
12, 2002
MEMORANDUM FOR
COMMISSIONER ROSSOTTI
FROM: (for) Pamela J. Gardiner /s/ Gordon C.
Milbourn III
Deputy Inspector General for
Audit
SUBJECT: Final Management Advisory Report – The
Internal Revenue Service’s Response to the Falling Level of Income Tax
Examinations and Its Potential Impact on Voluntary Compliance (Review #
200130039)
This
report presents the results of our review to
(1) analyze revenue agent and tax auditor examination trends from Fiscal Year
(FY) 1997 to 2001, (2) evaluate what factors affected the amount of additional
taxes they recommended, and (3) assess the Internal Revenue Service’s (IRS)
ongoing efforts to improve their examination results.
In
summary, in recent years the Congress and other stakeholders have raised
concerns about the declining examination coverage rate and potential effect on
voluntary compliance. From FY 1997 to
2001, the number of income tax return
examinations fell 51 percent, from 1.6 million to 779,000 returns examined,
while the number of income tax returns filed grew 8 percent, from 128 million
to 138 million returns. Thus, income
tax examination coverage fell 56 percent for the same period, from 1.27 percent
of all income tax returns filed to 0.56 percent, while the associated
recommended examination assessments declined 29 percent, from $24.9 billion to
$17.7 billion.
The
decline in the IRS examination rate has important causes and effects. First, the decline is being driven by two
major factors: (1) a reduction in the
number of Income Tax Revenue Agents and Tax Compliance Officers between FY 1997
and FY 2001, and (2) an increase in the time applied to examine each return
over the same period. Secondly, as a
result, the decline in the number of income tax return examinations is directly
contributing to the associated drop in the recommended examination assessments made
in two important examination programs, the Non-Coordinated Industry Case
Program and the Office Examination Program.
Academic studies have shown that examinations are a potent tool to
foster voluntary tax reporting compliance and that the indirect impact of the
examinations – the amount of tax voluntarily reported on tax returns nationwide
– is significantly larger than the direct revenue that results from the
examinations themselves. In its January
2002 report, the IRS Oversight Board stated that its most recent survey found
that between 1999 and 2001 there was an 11-point drop in the number of
Americans that consider it unacceptable to cheat on their income taxes. These falling numbers suggest that voluntary
compliance may be eroding, which could be the ultimate impact, and the one of
greatest concern.
To
address the decline in the examination coverage rate and the potential effect
on voluntary compliance, the IRS has taken both short-term and long-term
actions to reverse the decline in income tax return examinations. These actions include: (1) reducing
details of Income Tax Revenue Agents and Tax Compliance Officers to provide
taxpayer assistance during the tax return filing season, (2) hiring more Income
Tax Revenue Agents and Tax Compliance Officers, (3) improving income tax
examination efficiency, (4) evaluating work processes to improve the delivery
of the examination program, and (5) implementing strategies to improve
voluntary compliance that permit a reduced reliance on income tax examinations.
Currently,
none of the business results indicators directly measures the effect
examinations are having on voluntary tax reporting compliance, which is the
primary purpose for an examination. To
foster voluntary tax reporting compliance we recommend:
·
The Commissioners of the Large and Mid-Size Business (LMSB)
Division and the Small Business/Self-Employed (SB/SE) Division accelerate
implementing an examination strategy based on issue management.
·
The Commissioners of the LMSB and SB/SE Divisions continue
to obtain stakeholder input concerning the use of a more issue-based
examination approach to develop less intrusive and time-consuming techniques.
·
The Director, Organizational Performance Division develop a
business results component for the LMSB and SB/SE Divisions’ respective
“Balanced Measures” that indicates the impact examinations are having on
voluntary tax reporting compliance.
·
The Director, Research, Analysis, and Statistics of Income
test the feasibility of conducting an in-depth study across all income tax
return classes to determine the amount of income tax voluntarily reported as a
result of income tax examinations.
Management’s
Response: Management’s response was due on June 3,
2002. As of June 10, 2002, management
had not responded to the draft report.
Copies of this
report are also being sent to the IRS officials who are affected by the
recommendations. Please contact me at
(202) 622-6510 if you have questions or Gordon C. Milbourn III, Assistant
Inspector General for Audit (Small Business and Corporate Programs), at (202)
622-3837.
Appendix I – Detailed Objectives, Scope, and Methodology
Appendix II – Major Contributors to This Report
Appendix III – Report Distribution List
Appendix IV – Analysis of Income Tax Return Examination Trends
from Fiscal Year 1997 to 2001
The Internal Revenue Service (IRS) views the examination of
income tax returns as an important tool to encourage voluntary compliance. One measure of the IRS’ overall examination
program is the “examination coverage rate,” commonly known as the “audit rate,”
which is figured by dividing the number of returns examined by the total number
of tax returns filed in the previous calendar year.
In the last 4 years, overall income tax return examination
coverage fell 56 percent, from 1.27 percent in Fiscal Year (FY) 1997 to 0.56 percent
in FY 2001. Historically, this rate has
fluctuated from year-to-year, but has been in a continual long-term
decline. This can be illustrated in the
declining coverage for individual examinations from FY 1981 to FY 2001, shown
in Figure 1.
Historically, the IRS has identified insufficient staff
resources and increased return filings as the reason for declining examination
coverage rates. For example, the IRS
Commissioner’s 1990 Annual Report stated that the overall individual
examination coverage rate had fallen from 0.92 percent in FY 1989 to 0.80
percent in FY 1990. This decline was
attributed to an increase in returns filed and insufficient staffing increases.
Figure 1 was
removed due to its size. To see the
figure, please go to the Adobe PDF version of the report on the TIGTA Public
Web Page.
Recently, the Congress and other stakeholders have expressed
concerns about the declining examination coverage rate and the potential effect
on voluntary compliance. On March 26,
2001, the IRS Commissioner wrote to the Congress, stating:
With the use of document matching as well
as other return verification techniques that will eventually be enabled by new
technology, it is my view that there is no need to return to the levels of
individual audit coverage that existed even five years ago, which was three
times the FY 2000 level. However, our
strategic plan sets forth an approach in the short run to stabilize our level
of traditional compliance activities, such as individual audits, at or slightly
above current levels and to focus them on areas where they are most
required. In the long run, we will rely
on our business systems modernization program to increase the effectiveness and
efficiency of these activities.
Again in testimony before a subcommittee of the House
Appropriations Committee on February 28, 2002, the Commissioner stated, We
believe that compliance activity levels will increase over the next three
years, and …[we] will also be able to better identify and focus on key
compliance problem areas.
The IRS defines three types of voluntary compliance:
·
Filing compliance – the timely filing of any required
return.
To verify information on income tax returns as a way to help
achieve reporting compliance, the IRS uses two primary methods. The first is document matching, which
verifies third party information documents to amounts reported on income tax
returns. This program closed over 1.6
million returns in FY 2001. The second
method is the income tax return examination, which may examine a tax return for
a variety of reasons and take place in one of several ways, all of which
compare entries on the taxpayers’ tax return to the taxpayers’ own books and
records. In FY 2001, the IRS examined
approximately 779,000 income tax returns.
This review is part of our FY 2002 emphasis focusing on the
Large and Mid-Size Business (LMSB) and the Small Business/Self-Employed (SB/SE)
Divisions’ strategic initiatives. The
review was conducted in accordance with the President’s Council on Integrity
and Efficiency’s Quality Standards for
Inspections between October and December 2001. On-site work was performed in the LMSB and SB/SE Divisions’
Headquarters in Washington, DC, and at the IRS offices in Springfield, New
Jersey.
Details on our objectives, scope, and methodology are
presented in Appendix I. Major contributors to this report are listed in
Appendix II.
Like the Congress and other stakeholders, the IRS is
concerned about the declining examination rates and results. To address these current declines, the IRS
is implementing both short-term and long-term actions, such as increasing
resources available to examine tax returns, improving its examination work
processes, and implementing strategies to improve voluntary compliance.
The IRS has reduced details of Income Tax Examiners to
Customer Service during the tax return filing season
In the past several tax return filing seasons, the IRS
detailed Examination function employees to help provide better levels of
customer service by answering incoming telephone calls and working at walk-in
centers. In FY 2000, the IRS
transferred 420 Revenue Agent and 185 Tax Auditor staff years to provide
taxpayer assistance during the filing season.
This reduced 605 staff years from the examination programs. However, beginning in FY 2001 the IRS
reduced examination staff details to customer service by 74 percent from the FY
2000 level. This should have an
immediate effect on increasing the examination rate and results achieved.
The IRS has hired additional Examination staffing
To further increase Examination staffing, the IRS hired 646 new
Revenue Agents and 126 new Tax Compliance Officers (TCO) in June and July 2001. This hiring initiative will likely be a
longer-term solution, since these new employees usually spend several years
training and gaining experience before developing into fully productive
journeyman income tax examiners.
The IRS is in the process of improving income tax
examination efficiency
Actions the IRS is undertaking to improve examination
efficiency and reduce examination time per return will have mid to long-term
effects. Both the SB/SE and LMSB
Divisions are analyzing their examination processes and procedures to identify
ways to decrease the hours needed to perform examinations. So far the SB/SE Division’s analysis has
shown the need for more first line manager involve-ment. Specific recommendations included the need
for Team Managers to:
·
More effectively use management reports to monitor
cases with high time charges, inactivity and other indicators of trouble, so
that they can proactively address problems.
The LMSB Division is implementing an improvement initiative
to reduce Direct Examination Staff Years (DESY) charges. For the Coordinated Industry Case (CIC)
Program, the goal is a 20 percent reduction over 2 years that will reallocate
DESY to the Industry Case (IC) Program.
On the IC Program, the goal is a 20 percent reduction in time applied
per return over 3 years.
The IRS is evaluating work processes to improve the delivery
of the Examination Program
The IRS initiative to reengineer work processes to improve
efficiency and effectiveness will have mid- to long-term effects. In FY 2001, the SB/SE Division began a
12-month project to reengineer its examination process. Changes will begin in FY 2002. The LMSB Division launched a similar
post-filing improvement process at the beginning of FY 2002.
The LMSB Division has also developed an automated workload
analysis system to match human resources to location and risk. The LMSB Division intends to perform this
analysis annually using the previous year’s return data, completing it no later
than April of each year.
The LMSB Division workload analysis was used to support
decisions for promotions and the realignment of employees and teams between
territories, field directorships, and industries. The analysis was also used to better match resources with
workload and to support the decision to transfer the $5 to $10 million-asset
work from the LMSB Division to the SB/SE Division to better meet the customer
needs of that taxpayer segment beginning in FY 2002.
The IRS is implementing strategies to improve voluntary
compliance that will permit a reduced reliance on income tax examinations
In another longer-term initiative, the IRS plans to address
voluntary compliance through taxpayer education activities, partnership
outreach efforts with significant stakeholder groups, and voluntary agreements
with taxpayers.
The IRS believes an important contribution towards
increasing overall compliance will be the information sharing process between
its examination functions, and taxpayer education and communication
functions. Further, partnership
outreach feedback will also be used to design, develop and deliver products and
services focused on identified customer needs.
Some of the outreach services now offered by the IRS are the following.
·
The SB/SE Division’s Voluntary Compliance Agreement
Program permits a taxpayer to enter into an agreement for a specific tax
issue. Tip Reporting Agreements are an
example of a Voluntary Compliance Agreement.
·
The LMSB Division’s Pre-filing Agreement (PFA) Program
provides for a pre-filing examination.
This process can resolve some tax issues more effectively and
efficiently than a post-filing examination, because the taxpayer and the IRS
have more timely access to the relevant records and personnel. The TIGTA reviewed the PFA pilot in its
report titled, The Pre-filing Agreement Pilot Project Was Successful, But Faces
Challenges in Converting to an Operational Program (Reference Number
2001-35-125, dated August 2001).
While we are encouraged by the IRS’ efforts to reverse the
declining examination coverage trend, we are concerned whether the planned
actions will significantly reverse the downward course, especially in the near
future. In January 2002, the IRS
Oversight Board reported that its most recent survey found that between 1999
and 2001 there was an 11-point drop, from 87 percent to 76 percent, in the
number of Americans that consider it unacceptable to cheat on their income
taxes. This sharp decline suggests
there may be an erosion in voluntary compliance.
The Examination Program has been in decline
In the years immediately prior to and during the time frame
of this 11-point drop, the IRS’ examination rate and other key measures were
also in decline. In our opinion, this
continuous decline in the IRS examination rate may be having an adverse affect
on voluntary compliance.
Between FY 1997 and 2001, the number of income tax return
examinations fell 51 percent, from 1.6 million to 779,000 returns examined,
while the number of income tax returns filed grew 8 percent, from 128 million
to 138 million. Thus, income tax
examination coverage fell 56 percent for the same period, from 1.27 percent of
all income tax returns filed to 0.56 percent, while the associated recommended
examination assessments declined 29 percent, from $24.9 billion to $17.7 billion.
The decline in examination coverage rates and the
corresponding loss in examination output can be illustrated in detail by
analyzing the Non-CIC Program of Revenue Agent income tax examinations. The Non-CIC Revenue Agent income tax
examinations declined 62 percent, from 306,769 returns in FY 1997 to 117,174
returns in FY 2001. For extensive
information on the different IRS examination programs and a detailed analysis
of examination program trends from FY 1997 to FY 2001, see Appendix IV.
Many factors affect examination tax assessments
The factors that affect the amount of additional taxes
assessed are complex. Numerous factors
can contribute to the amount of additional assessments, such as changes in the
examination requirements caused by the IRS Restructuring and Reform Act of 1998
(RRA 98), organizational changes, and employee morale. The direct effects of these factors are
difficult to objectively assess.
Two resource factors must be analyzed. The first is the number of employees
available to perform examinations.
Between FY 1997 and FY 2001 the number of Income Tax Revenue Agents
declined 26 percent, from 10,591 to 7,848.
The second element to analyze is the time applied to examine each tax
return. This is a measure of
efficiency. Between FY 1997 and FY 2001,
the hours of Direct Examination Time (DET) applied per return increased 47 percent,
from 30 hours to 44 hours.
This change in efficiency had a dramatic effect on
examination coverage for Non-CIC Program returns. Though we cannot objectively quantify the numerous causes
contributing to the decline in the number of income tax examinations, such as
dislocations caused by the IRS restructuring and changes in employee morale, we
can illustrate the erosion due to the increase in DET required to close Non-CIC
examinations. If the FY 1997 time
applied per return had been maintained in FY 2001, the IRS would have examined
over 45,000 more returns than it did (see Figure 2). Put another way, the change in efficiency had the effect of
eliminating more than 800 Full Time Equivalents (FTE) from income tax return
examinations in FY 2001, above those already lost due to the decline in
staffing levels. Thus, the drop in
output is attributable to more than just the decline in staffing
resources. Due to this decline in
output, recommended examination assessments directly attributable to income tax
return examinations declined 54 percent, from $7.9 billion in FY 1997 to $3.7 billion
in FY 2001.
Figure 2 was
removed due to its size. To see the
figure, please go to the Adobe PDF version of the report on the TIGTA Public
Web Page.
Examinations impact voluntary compliance
Voluntary income tax compliance is determined by a wide
variety of factors that interact differently for each taxpayer. Among the many factors are the taxpayer’s
perception of the fairness of the tax system, the taxpayer’s own honesty, and
the taxpayer’s perception of being detected by an income tax examination.
One factor affecting voluntary compliance that has received
academic scrutiny is the effect of income tax examinations on voluntary tax
reporting compliance. Though we cannot
quantify the effect in this report, two academic studies have found a significant
correlation between the examination coverage rate and the level of voluntary
compliance. A third study using a
controlled experiment showed that the threat of an examination increases income
tax reporting compliance of both low income and middle income taxpayer groups.
In their study titled, “The Effect of Audit Rate on the
Federal Individual Income Tax, 1977-1986,” professors Jeffrey A. Dubin, Michael
A. Graetz, and Louis L. Wilde found the examination rate has a significant
positive effect on the tax reported per return. The authors interpreted the positive effect of the examination
rate on reported tax per return and assessed liability per return as arising
from increased compliance. They
concluded that there was a strong correlation between the examination rate and
overall taxpayer compliance. The
authors projected that the indirect effects of examinations produced six out of
every seven dollars of additional revenue.
An internal IRS study titled, “The Determinants of
Individual Income Tax Compliance,” also found that examinations have a strong,
positive effect on reporting compliance.
Using data aggregated at the state level and compiled for a 10-year
period between 1982 and 1991, the author developed an econometric model that
estimates the average indirect effect of field and office examinations started
in 1991. He concluded that for every
$1.00 in tax adjustments on an examination opened in 1991, $11.60 of tax was
voluntarily reported on individual income tax returns as an indirect effect.
Similar to the earlier study, the author determined that if
the examination rate had been held constant at its 1982 level of 1.62 percent
(instead of declining to 0.65 percent as it had), the cumulative impact through
1991 would have been that an additional $257 billion of tax would have been voluntarily
reported due to the indirect effect.
The author contended that:
This is strong evidence that audits are a potent tool to
foster voluntary compliance. In fact,
since the effect is significantly larger than the direct revenue effect of the
audits, these results suggest that the allocation of audit resources (which is
currently based almost solely on their direct revenue potential) ought to be
modified to give more weight to this indirect effect on voluntary compliance.
In a third study titled, “The Determinants of Income Tax
Compliance: Evidence From a Controlled
Experiment in Minnesota,” professors Marsha Blumenthal, Charles Christian, and
Joel Slemrod describe a controlled experiment carried out with the Minnesota
Department of Revenue. In the
experiment, a stratified sample was selected based on three levels of 1993
income: low-income with Adjusted Gross
Income (AGI) less than $10,000; middle-income with AGI between $10,000 and
$100,000; and high-income with AGI over $100,000. The sample was split into a treatment group and a control
group. The Minnesota Department of
Revenue informed the treatment group by mail that both their state and federal
income tax returns would be “closely examined.”
The resulting increases in reported income and tax liability
between the treatment group and the control group show that the heightened
threat of examination increases income tax reporting compliance among low and
middle-income taxpayers. However, with
high-income taxpayers the threat had the opposite effect and reported income
and tax liabilities actually decreased.
The authors explained
…there is reason to suspect that high-income taxpayers may
react by reporting even less income than before, based on a perception that an
audit is in reality a negotiation process for which an initial ‘low bid’ may be
optimal.
Therefore, based on the results of these previous studies,
it is likely the decline in the examination rate has had a detrimental effect
on tax reporting compliance.
The IRS’ approach to examinations did not change with
the changing environment
Even though the IRS was aware of at least two of these
studies and the indirect effect that the examination coverage rate had on
voluntary compliance, the fundamental approach to increasing coverage was not
altered as the staff available to conduct examinations declined. This is due at least in part to the way
examination activities are measured.
The IRS policy statement on the selection of returns for
examination describes both the purpose of tax return examinations and the
concept of coverage:
The primary objective in selecting returns for examination
is to promote the highest degree of voluntary compliance on the part of
taxpayers. This requires the exercise
of professional judgment in selecting sufficient returns of all classes of
returns in order to assure all taxpayers of equitable consideration, in
utilizing available experience and statistics indicating the probability of
substantial error, and in making the most efficient use of examination staffing
and other resources.
Prior to the passage of the RRA 98, the IRS used a series of
productivity indicators to measure the success of its examination program. These measures included:
·
Recommended assessments per hour of direct examination
time (dollars per hour).
The IRS’ historic emphasis on achieving numeric targets did
not adequately consider the impact on quality case work, fair treatment of
taxpayers, and employee satisfaction.
To comply with the RRA 98 and the Government Performance and
Result Act of 1993 (GPRA), the IRS developed balanced measures as part of the
effort to modernize itself and to reflect its priorities as articulated in its
mission and strategic goals. To promote
balance, three divergent measures are used.
·
Business results – The goal of this element is to
generate a productive quantity of work in a quality manner and to provide
meaningful outreach to all customers.
·
Customer satisfaction – The goal of this element is to
provide accurate and professional services to internal and external customers
in a courteous, timely manner.
In addition to customer and employee feedback to evaluate
the success of the field and office examination program, the IRS uses business
results indicators like:
·
Number of cases/returns closed.
These measures have a peripheral connection to the old
productivity indicators that are still in use as diagnostic measures for
planning and control purposes. However,
none of the business results indicators directly measures the effect
examinations are having on voluntary tax reporting compliance, which is the
primary purpose for an examination.
Therefore, in our opinion perhaps the most important aspect of
examination activity, the indirect effect on voluntary tax reporting
compliance, is not measured.
Both the LMSB and the SB/SE Division Commissioners have
recognized that a fundamental change in the IRS’ examination strategy is
needed. Both have initiatives to
implement strategies involving “issue management.” This would shift from examining an entire return to examining
specific issues on the return.
The LMSB and SB/SE Divisions are at different points in
implementing an issue management strategy.
The LMSB Division currently has four sub-teams in various stages of
implementing parts of its issue management strategy. They have worked with a contractor to design the different facets
of the issue management strategy. The
LMSB Division has also involved stakeholders in the design process.
On the other hand, the SB/SE Division is still in the
reengineering process. They have
identified issue management as part of a risk-driven examination strategy
intended to reduce scope, depth, and taxpayer burden through a more focused
examination approach that is critical to the future examination program. Their approach has also involved outside
contractors and stakeholders in the design process.
We believe that properly implemented, the issue management
strategy will contribute to solving the declining examination coverage problem
by reducing the overall amount of time for most income tax examinations, thus
permitting more income tax returns to be examined. This will increase examination coverage, in turn fostering
voluntary tax reporting compliance, provided income tax examination staffing
levels stabilize. An additional
benefit for taxpayers would be that examinations would be less intrusive and
time-consuming.
During closing discussions with
managers in the LMSB and SB/SE Divisions concerning the issues being reported,
LMSB Division managers stated that shrinking resources directly affect future
examination coverage. The initial LMSB
Division model was designed to have 7,200 employees; however, a recent
assessment by the Chief Financial Officer’s office shows a 4,840 employee base
for FY 2003.
LMSB Division management described two large and increasing
demands for resources. The first demand
is the resource commitment to combat abusive corporate tax shelters. The second demand is the ever-increasing
concern for “Revenue Protection.” This
is the filing of both formal and informal claims for the refund of previously
paid taxes by the LMSB Division’s taxpayer population, many of which are
disallowed. For example, in FY 2001 the
CIC Program disallowed $6 billion in claims on 1,044 tax returns, while the IC
Program disallowed $362 million on 1,239 income tax returns. In the first half of FY 2002 the CIC Program
disallowed $1.5 billion (58 percent) of the $2.6 billion in claims.
SB/SE Division management described several impedi-ments they
are facing. First, they will be
allocating a significant amount of resources to examinations in the National
Research Program over the next several years.
Other impediments include inadequate information system technology and
support. Due to these limitations, the
SB/SE Division plans to concentrate its discretionary work in the Non-CIC and
Office Examination Programs around Unidentified Income (UI) DIF, a system they
believe will identify the most noncompliant returns with unreported income.
The IRS Commissioner, who has the overall responsibility for
the IRS’ examination resources, should direct:
1.
The Commissioners of the LMSB and SB/SE Divisions to
accelerate their implementation of an examination strategy focusing on issue
management, rather than the current return-based approach, for income tax
examinations in their respective examination programs. The benefits of such a strategy are:
·
It would reduce the overall amount of time for most
income tax examinations, permitting more income tax returns to be
examined. This will increase
examination coverage, in turn fostering voluntary tax reporting compliance.
2. The Commissioners of the LMSB and SB/SE Divisions to continue
to obtain stakeholder input to help develop techniques to make issue-based
examinations less intrusive and time consuming.
3.
The Director, Organizational Performance Division to develop a
business results component for the LMSB and SB/SE Divisions’ respective
“Balanced Measures” that indicates the impact examinations are having on
voluntary tax reporting compliance. The
benefit of such an indicator is that it would assess whether the examination
programs are meeting their primary objective of encouraging voluntary tax
reporting compliance.
4.
The Director, Research, Analysis, and Statistics of Income,
with assistance as needed from the LMSB Division’s Director, Strategy, Research
and Program Planning and the SB/SE Division’s Director Strategy, Research and
Performance Management, to test the feasibility of conducting an in-depth study
across all income tax return classes to determine the indirect effect that
income tax examinations have on amounts voluntarily reported. The study design should include information
to determine taxpayer responses to issue management examinations rather than to
full return examinations. This will
permit the IRS to tailor examination strategies best suited for a specific
income tax return class based on both the direct and indirect effects of
examinations.
Management’s Response: Management’s response was due on June 3, 2002. As of June 10, 2002, management had not
responded to the draft report.
Appendix I
Detailed Objectives, Scope, and Methodology
The objectives of the review were to (1) analyze revenue
agent and tax auditor examination trends from Fiscal Year (FY) 1997 to 2001,
(2) evaluate what factors, if any, reduced the amount of additional taxes
recommended, and (3) assess the Internal Revenue Service’s (IRS) ongoing
efforts to improve its examination results.
On-site tests were performed in the Large and Mid-Size Business (LMSB)
Division Headquarters, the Small Business/Self-Employed (SB/SE) Division
Headquarters, and at the IRS offices in Springfield, New Jersey.
To achieve the assignment’s objective we extensively relied
on publications issued by the IRS and on internal management reports. We did not establish the reliability of this
data because extensive data validation tests were outside the scope of this
audit. Except as noted above, the
Treasury Inspector General for Tax Administration’s (TIGTA) work was conducted
in accordance with the President’s Council on Integrity and Efficiency’s Quality
Standards for Inspections.
The specific tests included the following:
I.
Using the closed examined
return Audit Information Management System (AIMS) database, reviewed the number
and type of income tax examinations conducted by the Examination Division and
its successor functions in the LMSB and SB/SE Divisions for Fiscal Year (FY) 1997
through FY 2001 to determine trends.
The analysis included determining average dollars per return, average
dollars per hour, average hours per return, average cycle-days per return, and
the average no-change rate per return based on IRS tax return classes (Activity
Code).
II.
Reviewed the mission
statements of the LMSB and SB/SE Divisions with respect to tax reporting
compliance, the IRS’ balanced measures and the diagnostic measures used to
manage the tax reporting compliance program of each division.
III.
Determined the causes for the
decline in the number of tax return examinations and the actions the LMSB and
SB/SE Divisions are implementing to address it.
A.
Discussed with management the
factors affecting examination productivity and how the LMSB and SB/SE Divisions
are addressing the decline.
B.
Reviewed the development
process decks of the SB/SE Division’s Examination Reengineering Project and the
December 2001 TIGTA Management Advisory Report about the project.
C.
Reviewed meeting minutes and
action plans addressing the decline in the number of examinations to identify
specific IRS initiatives.
D.
Reviewed the specific actions
management has implemented to address the decline in examinations.
E.
Analyzed Table 37 “Examination
Program Monitoring” for FY 1997 through FY 2001 to determine:
1.
The decline in the number of revenue agents and tax auditors
available to examine income tax returns.
2.
The change in the grade
structure of the revenue agent and tax auditor workforce.
3.
The decline in staff years of
revenue agents and tax auditors devoted to examination of income tax returns
and the associated increase in non-return examination activities, such as
details to customer service and Headquarters.
F.
Reviewed the results of the
employee satisfaction survey conducted by the LMSB and SB/SE Divisions to
identify morale issues, training issues, and other potential problems affecting
income tax return examination productivity.
G.
Reviewed information from the
IRS Commissioner’s Complaint Processing and Analysis Group on the number of the
IRS Restructuring and Reform Act of 1998 Section 1203 complaints made,
investigations initiated, and resulting actions taken against employees through
FY 2001.
IV.
Determined the reduction in
revenue due to the decline in the number of income tax return examinations.
A.
Estimated the reduction in
revenue due to the decline in the number of examinations using the AIMS closed
return databases for FY 1997 through FY 2001.
B.
Estimated the increase in
examination cycle-time using the AIMS closed return databases for FY 1997
through FY 2001.
C.
Reviewed “The Effect of Audit
Rates on the Federal Individual Income Tax, 1977-1986” by Jeffrey A. Dubin,
Michael J. Graetz, and Louis L. Wilde and “Determinants of Individual Income
Tax Compliance” by the IRS Statistics of Income Division. Due to the complexity of the models and the
inability to obtain the necessary data, we were unable to determine the decline
in tax reporting compliance associated with the decline in the rate of
examinations of individual income tax return examinations. Also reviewed “The Determinants of Income
Tax Compliance: Evidence From a
Controlled Experiment in Minnesota” by professors Marsha Blumenthal, Charles Christian,
and Joel Slemrod.
Appendix II
Major Contributors to This Report
Gordon C. Milbourn III, Assistant Inspector
General for Audit (Small Business and Corporate Programs)
Phillip Shropshire, Director
Frank Dunleavy, Audit Manager
Earl Charles Burney, Senior Auditor
William
Tran, Auditor
Appendix III
Deputy
Commissioner N:DC
Commissioner,
Large and Mid-Size Business Division LM
Commissioner,
Small Business/Self-Employed Division S
Deputy
Commissioner, Large and Mid-Size Business Division LM
Deputy Commissioner,
Small Business/Self-Employed Division S
Director,
Organizational Performance Division
N:CFO:O
Director,
Research, Analysis, and Statistics of Income
N:ADC:R
Director,
Centralized Workload and Selection Development, Small Business/Self-Employed
Division S:C
Director,
Compliance, Small Business/Self-Employed Division S:C
Director,
Communications, Technology, and Media Industry, Large and Mid-Size Business
Division LM:CTM
Director,
Financial Services Industry, Large and Mid-Size Business Division LM:F
Director,
Heavy Manufacturing and Transportation Industry, Large and Mid-Size Business
Division LM:HCT
Director,
Natural Resources and Construction Industry, Large and Mid-Size Business
Division, LM:NR
Director,
Retail, Food, and Pharmaceuticals Industry, Large and Mid-Size Business
Division, LM:RFP
Director,
Strategy, Research, and Performance Management, Small Business/Self-Employed
Division S:SR
Director,
Strategy, Research, and Program Planning, Large and Mid-Size Business
Division LM:SR
Chief Counsel CC
National Taxpayer Advocate
TA
Director, Legislative Affairs CL:LA
Director, Office of Program Evaluation and Risk
Analysis N:ADC:R:O
Office of
Management Controls N:CFO:F:M
Audit Liaisons:
Commissioner N:C
Deputy
Commissioner N:DC
Commissioner, Large and Mid-Size Business
Division LM
Commissioner,
Small Business/Self-Employed Division S
Appendix IV
Analysis
of Income Tax Return Examination Trends from Fiscal Year 1997 to 2001
Overall income tax “examination coverage,” commonly known as
the “audit rate” (computed as income tax examinations closed in the fiscal year
divided by the tax returns filed for the previous calendar year), fell 56
percent between Fiscal Year (FY) 1997 and FY 2001, from 1.27 percent of all
income tax returns filed to 0.56 percent.
During this same period overall income tax return filings grew 8
percent, from 128 million to 138 million returns, while the number of income
tax return examinations fell 51 percent, from 1.6 million to 779,000 returns
examined (see Figure 3).
Figure 3 was removed due to its size. To see the figure, please go to the Adobe PDF version of the report on the TIGTA Public Web Page.
Income tax return examinations are the responsibility of
three of the four Internal Revenue Service (IRS) operating divisions (see
Figure 4).
·
The Wage and Investment (W&I) Division has
jurisdiction over approximately 122 million taxpayers accounting for 94 million
returns. Almost all of the income for
these taxpayers is reported to the IRS by third parties, and the vast majority
of taxes are collected through third-party withholding. The W&I Division examined over 262,000
individual income tax returns in FY 2001.
Figure 4 was
removed due to its size. To see the
figure, please go to the Adobe PDF version of the report on the TIGTA Public
Web Page.
We previously described in detail the increase in tax return
filings and the decline in the number of tax return examinations in the report
titled, Management Advisory Report:
Tax Return Filing and Examination Statistics (Reference Number
2001-30-175, dated September 2001). In
addition, the decline has been reported in the media as raising concerns in the
Congress, the IRS Oversight Board has expressed concerns in its January 2002
Annual Report, and the decline in individual income tax examinations was the
subject of a General Accounting Office report titled, IRS AUDIT RATES – Rate
for Individual Taxpayer Has Declined But Effect on Compliance Is Unknown
(GAO-01-484, dated April 2001).
The vast majority of income tax examinations are
correspondence examinations of individual income tax returns, handled out of
the 10 IRS compliance centers, but these account for less than 10 percent of
the recommended tax assessments. In FY 2001
the IRS conducted 534,519 correspondence examinations (69 percent of all income
tax return examinations) and recommended assessments of nearly $1.4
billion. This represented a 34 percent
decline in income tax examinations from the 1997 level when the IRS conducted
811,526 correspondence examinations (50 percent of all income tax return
examinations) and recommended assessments of $2.6 billion. Beginning in FY 2001 these compliance center
correspondence examinations became the responsibility of the IRS’ new W&I
and SB/SE Divisions.
In contrast, the IRS’ field and office examination programs
account for about 92 percent of the recommended examination assessments made
each year, but now account for significantly less than 50 percent of the
returns examined. The field and office
examination programs conduct face-to-face income tax return examinations either
at the taxpayer’s place of business or at an IRS office. In FY 2001 the IRS conducted 245,082 field
and office examinations (31 percent of all income tax return examinations) and
recommended assessments of $16.3 billion.
This represented a 70 percent decline in income tax examinations from
the FY 1997 level, when the IRS conducted 816,829 field and office examinations
(50 percent of all income tax return examinations) and recommended nearly $22.4
billion in assessments (see Figure 5).
Beginning in FY 2001 the field and office examination programs became
the responsibility of the LMSB and the SB/SE Divisions.
Figure 5 was
removed due to its size. To see the
figure, please go to the Adobe PDF version of the report on the TIGTA Public
Web Page.
The field and office examination program consists of three
primary components:
·
The Office Examination Program operated by the SB/SE
Division and conducted by employees designated as Tax Compliance Officers
(TCO), formerly known as Tax Auditors.
In the Non-CIC Program (see Figure 6), Revenue Agents’
income tax examinations declined 62 percent between FY 1997 and FY 2001. In FY 1997, Revenue Agents examined 306,769
returns, or 19 percent of all income tax returns examined that year. By FY 2001, Revenue Agents examined 117,174
returns, or 15 percent of income tax returns examined that year. The decline in examinations was composed of:
·
A decline in individual income tax return examinations
of 63 percent, from 209,551 to 77,835 returns, with a corresponding decline in
recommended assessments from $4 billion to $1.5 billion (63 percent).
·
A decline in corporation income tax return examinations
of 70 percent, from 65,217 to 19,271 returns, with a corresponding decline in
recommended assessments from $3.8 billion to $2.0 billion (47 percent).
·
An increase in fiduciary income tax return examinations
of 165 percent, from 1,889 to 5,015 returns, with a corresponding increase in
recommended assessments from $49.7 million to $119.8 million (141 percent).
·
A decline in partnership income tax return examinations
of 53 percent, from 7,105 to 3,307 returns.
All these changes, taken together, resulted in a 53 percent
decline in recommended assessments, from $7.9 billion in FY 1997 to $3.7 billion
in FY 2001.
Figure 6 was
removed due to its size. To see the
figure, please go to the Adobe PDF version of the report on the TIGTA Public
Web Page.
With the end of FY 2001 the IRS completed its first full
year of operation in its restructured form.
Table 37, Examination Program Monitoring report shows that the SB/SE
Division portion of the Non-CIC program examined 94,960 returns, or 12 percent
of the income tax returns examined that year and 84 percent of the returns
examined in the Non-CIC Program, resulting in recommended assessments of $1.5 billion. The LMSB Division portion of the Non-CIC
Program, now referred to as the Industry Case (IC) Program, examined 18,341 returns,
or 2 percent of the income tax returns that year and 16 percent of the returns
examined in the Non-CIC Program, resulting in recommended assessments of $2.0 billion. Table 1 shows, for each type of income tax
return, the number of returns filed, the number of returns examined by each
division, the percentage of examination coverage contributed, and each division’s
percentage contribution to the Non-CIC Program in FY 2001.
|
Table 1: |
Returns Examined
in Non-CIC Program by the LMSB and SB/SE Divisions (FY 2001) |
||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Returns
Examined |
Examination
Coverage |
Percentage of Non-CIC
Examinations |
|||||
|
Return Type |
Returns Filed |
Total |
LMSB Division |
SB/SE Division |
Total |
LMSB Division |
SB/SE Division |
LMSB Division |
SB/SE Division |
|
Individual |
127,097,400 |
74,340 |
6,551 |
67,789 |
0.06% |
0.01% |
0.05% |
9% |
91% |
|
Corporation |
2,453,000 |
19,046 |
7,686 |
11,360 |
0.78% |
0.31% |
0.46% |
40% |
60% |
|
Corporation $5 million and less |
2,343,000 |
11,459 |
1,430 |
10,029 |
0.49% |
0.06% |
0.43% |
12% |
88% |
|
Corporation more than $5 million |
87,700 |
7,587 |
6,256 |
1,331 |
8.65% |
7.13% |
1.52% |
82% |
18% |
|
Partnership |
2,066,800 |
3,245 |
791 |
2,454 |
0.16% |
0.04% |
0.12% |
24% |
76% |
|
Partnership $5 million and
less |
1,970,427 |
2,454 |
0 |
2.454 |
0.12% |
0.00% |
0.12% |
0% |
100% |
|
Partnership more than $5 million |
96,373 |
791 |
791 |
0 |
0.82% |
0.82% |
0% |
100% |
0% |
|
S Corporation |
2,887,100 |
11,655 |
2,790 |
8,865 |
0.40% |
0.10% |
0.31% |
24% |
76% |
|
S Corporation $5 million
and less |
2,839,599 |
8,865 |
0 |
8,865 |
0.31% |
0.00% |
0.31% |
0% |
100% |
|
S Corporation more than $5 million |
47,501 |
2,790 |
2,790 |
0 |
5.87% |
5.87% |
0.00% |
100% |
0% |
|
Fiduciary |
3,528,900 |
5,015 |
523 |
4,492 |
0.14% |
0.01% |
0.13% |
10% |
90% |
|
Total |
138,033,200 |
113,301 |
18,341 |
94,960 |
0.08% |
0.01% |
0.07% |
16% |
84% |
Source:
TIGTA Analysis of FY 2001 IRS Databook, Examination Program Monitoring,
Table 37 (FY 2001), and LMSB Division Partnership and S Corporation Data.
An even more dramatic decrease took place in the Office
Examination Program. The Office
Examination Program’s TCO individual income tax return examinations declined 77
percent between FY 1997 and FY 2001. In
FY 1997, Tax Auditors examined 505,834 returns, or 31 percent of all income tax
returns examined that year. By FY 2001,
TCOs examined 115,935 returns, or 15 percent of all income tax returns examined
that year. This resulted in a 77 percent
decline in recommended assessments, from $1.7 billion in FY 1997 to $394 million
in FY 2001 (see Figure 7).
Figure 7 was
removed due to its size. To see the
figure, please go to the Adobe PDF version of the report on the TIGTA Public
Web Page.
The CIC Program, in comparison to the Non-CIC Program and
the Office Examination Program, examines far fewer returns annually but
accounts for over 50 percent of the examination assessments. The number of income tax returns examined in
the CIC Program declined 21 percent, while recommended assessments declined
only 3 percent, between FY 1997 and FY 2001.
In FY 1997, the CIC Program examined 4,226 income tax returns (0.26 percent
of all income tax returns examined), recommending income tax assessments of
$12.6 billion (nearly 51 percent of all recommended examination
assessments). However, by FY 2001 the
percentage of all returns examined that was represented by CIC Program
examinations increased, as did the percentage of assessments, while the actual
number of returns fell. Specifically,
by FY 2001 the number of returns examined declined to 3,343 (0.43 percent of
all the income tax returns examined), with recommended examination assessments
of $12.2 billion (69 percent of all the examination assessments).
Many of these income tax returns examined were entities
related to the primary corporation returns under examination and included the
tax returns of individuals, corporations, partnerships, S corporations, and
fiduciaries. Therefore, a better
comparison of actual CIC Program activity for FY 1997 to FY 2001 period is
found by looking at the number of corporation income tax return examinations
that were closed. In FY 1997, the CIC
Program closed 2,795 corporate income tax returns, recommending additional
income tax assessments of $12.5 billion, and in FY 2001 it closed 2,550
corporation income tax returns, recommending additional income tax assessments
of $12.2 billion. This was a nine percent
decline in tax returns examined, but only a two percent decline in recommended
income tax assessments (see Figure 8).
Figure 8 was
removed due to its size. To see the
figure, please go to the Adobe PDF version of the report on the TIGTA Public
Web Page.
Though the CIC Program accounts for the vast majority of
recommended examination assessments, it examines a very small universe of
approximately 1,700 business taxpayers out of a filing population 10,300
corporation tax returns with assets of over $250 million. The program represents a fraction of the $205
billion in corporation income tax reported voluntarily each year. By contrast, the Income Tax Revenue Agents
of the Non-CIC Program are responsible for examining a portion of the remaining
2.4 million corporation returns, as well as portions of the 2.1 million
partnership returns, 2.9 million S corporation returns and 3.6 million
fiduciary returns filed annually. In
addition, the Non-CIC Program, along with the Office Examination Program and
the Compliance Center Examination Program, are responsible for examining a
portion of the 127 million individual income tax returns that voluntarily
report income taxes of $978 billion annually.
Figure 9 illustrates the amount of coverage contributed by the programs
and the continued decline in coverage of the Non-CIC and Office Examination
Programs.
Figure 9 was
removed due to its size. To see the
figure, please go to the Adobe PDF version of the report on the TIGTA Public
Web Page.
As stated in the report, the concept of coverage is to
examine sufficient returns of all classes in order to assure all taxpayers
of equitable consideration…and in making the most efficient use of examination
staffing and other resources with the objective of promoting the highest
degree of voluntary compliance.
Achievement of this objective is endangered with the declining overall
coverage resulting from the shrinking number of income tax return examinations
in the non-CIC and Office Examination Programs.
Declines in Field and Office Examination Compliance
Personnel Have Reduced Staff Years Available to Examine Income Tax Returns
As Figure 10 shows, between FY 1997 and FY 2001 the number
of Income Tax Revenue Agents and Tax Auditors, now referred to as TCOs,
declined significantly, reducing the number of staff years available for
conducting income tax examinations. At
the start of FY 1997 the IRS had 12,755 Compliance personnel dedicated to
income tax examinations, composed of 10,591 Revenue Agents and 2,164 Tax
Auditors. By the end of FY 2001 the
number of Income Tax Revenue Agents declined by 2,743 positions (nearly 26 percent)
to 7,848 positions (3,165 in the LMSB Division and 4,683 in the SB/SE
Division). The decline in staff caused
an associated reduction in total staff years available for examinations, from
approximately 10,023 staff years in FY 1997 to 7,620 staff years in FY 2001
(nearly a 24 percent decline).
The decline in Tax Auditors was even more dramatic. By the end of FY 2001 the number of Tax
Auditors had fallen by 987 positions (nearly 46 percent), to 1,177 TCOs in the
SB/SE Division. Again, the associated
drop in staff reduced total staff years available for examinations from about
2,133 in FY 1997 to 1,306 in FY 2001 (nearly a 39 percent decline).
Figure 10 was removed due to its
size. To see the figure, please go to
the Adobe PDF version of the report on the TIGTA Public Web Page.
Increase in Direct Examination Time to Complete an Income
Tax Return Examination Reduces the Number of Examinations that Can Be Completed
The hours of Direct Examination Time (DET) it took to
complete an examination by Income Tax Revenue Agents in the Non-CIC Program and
TCOs in the Office Examination Program increased significantly between FY 1997
and FY 2001 for various reasons, including procedural changes mandated by the
IRS Restructuring and Reform Act of 1998 that required agents to make third
party notifications. These additional
time requirements to complete examinations already in progress have reduced the
amount of time available to start and complete other examinations. The increase in DET has had the same effect
as eliminating nearly 1,089 Examination function staff positions on top of
those actually eliminated due to declining staff levels (see Table 2).
|
Table 2: |
The Loss in
Examination Staffing Resources Due to the Increase in Hours of DET Per Return
on Income Tax Return Examinations Conducted in FY 2001 |
||||||
|
|
|
||||||
|
Type of Examination |
FY 2001 Hours Per Return |
FY 1997 Hours Per Return |
Increase in DET Hours
Per Return |
Returns Examined in FY 2001 |
Total Additional Hours
of DET on FY 2001 Examinations |
Equivalent Positions |
|
|
Non-CIC Individual Examinations |
28 |
20 |
8 |
74,340 |
594,720 |
297 |
|
|
Non-CIC Corporate Examinations |
101 |
58 |
43 |
19,046 |
818,978 |
409 |
|
|
Non-CIC Partnership Examinations |
59 |
38 |
21 |
3,245 |
68,145 |
34 |
|
|
Non-CIC S Corporation Examinations |
62 |
46 |
16 |
11,655 |
186,480 |
93 |
|
|
Non-CIC Fiduciary Examinations |
26 |
17 |
9 |
5,015 |
45,135 |
23 |
|
|
Total
Non- |
|
|
|
113,301 |
1,713,458 |
857 |
|
|
Office Examinations |
8 |
4 |
4 |
115,922 |
463,688 |
232 |
|
|
Grand
Total |
|
|
|
229,223 |
2,177,146 |
1,089 |
|
Source: TIGTA Analysis of Examination Program
Monitoring, Table 37 (FY 1997 – FY 2001).
Though we cannot objectively quantify the numerous causes
contributing to the decline in the number of income tax examinations, such as
dislocations caused by the IRS restructuring and changes in employee morale, we
can illustrate the erosion due to the increase in DET required to close Non-CIC
and Office Examinations. Taking the DET
for each year from FY 1998 through FY 2001, we divided it by hours of DET per
return for FY 1997 to determine a predicted value of return closures for FYs 1998
to 2001. The difference between the
predicted value and the actual returns examined during those years represents
the lost output due to the increase in hours of DET per return (see Figure 11).
Figure 11 was
removed due to its size. To see the
figure, please go to the Adobe PDF version of the report on the TIGTA Public Web
Page.
It should be noted that some of the increase in time is due
to legislative and procedural changes intended to protect taxpayer rights. Also, FY 1997 was a peak year in most income
tax return examination categories for efficiency, as measured by hours of DET
per return. Therefore, the estimate of
the gap may be a “worst case” picture.
However, even if these factors could be removed from the analysis, a gap
would still remain (i.e., these factors alone do not explain how a 26 percent
decline in the number of Income Tax Revenue Agents led to a 62 percent drop in
the number of Non-CIC income tax return examinations).